Wednesday, August 31, 2011

Should we bring back reserve requirements for banks?

This post grew from a back and forth discussion with a commenter at Seeking Alpha. The commenter's position was that taking away the reserve requirement was an mistake, and in substituting quantitative control of bank reserves with control of interest rates instead, central banks ended up with a less useful control lever for money supply.

I believe that central banks cannot fully control the money supply, because private loan demand and government spending is what directly increases it. Central banks can indirectly control it by increasing the cost of credit, so that private loan demand plummets, or by decreasing cost, so private loan demand increases. But at this point in time, when people are already over-indebted and the cost of credit is already at zero, there’s not much more it can do to increase loan demand, and hence to increase money supply.


But just because the Fed controls the cost of credit doesn’t mean they should use it to mismanage the economy. Trying to stimulate more economic activity or bank lending by increasing reserves does not lead to more lending, and only results in fund misallocation, as investors who cannot earn positive income from investing in bonds allocate it to commodities instead (in the belief that inflation is just around the corner).

Now that rates are at the zero bound, monetarists insist that Fed stimulate more activity by quantitative easing, or swapping government bonds held by banks with more reserves. At least when the Fed was controlling the rate of credit, they were able to encourage more lending or they were able to decrease it. Now that it is manipulating reserves, what has that done to increase lending? And if you disagree with Fed control of rates (a position I confess to identify with), why would you advocate Fed control of reserves? Why should the Fed limit all reserves, when their real constraint to lending is their capital?

Bank capital

Taking away restraint on reserves in no way affects the restraint of banks to lend, so bringing it back will not fully constrain it when conditions are right for more lending, and they have adequate capital reserves. In this scenario, all a high reserve requirement will lead to is an increase in interest rates as banks vie to borrow the reserves they need to make the loans they want to give.

With a return to contra of reserve requirements, do you think banks will lend every reserve because they can? Wouldn't it be better and cleaner just to securitize a loan, so no heavy capital requirement is necessary? Whether or not the banks have legal reserve management mandates does not constrain banks anymore. What constrains them more is complying with Basel capital standards. If they are unable to comply with Basel, having no required reserves will do nothing in this world to enable banks to lend.

The real use of bank reserves

Increasing levels of vault cash, ATM networks, retail deposit program have have made unprecedented demands on banks to have the necessary reserves when needed. Hence, there has been a pragmatic shift by central banks away from most reserve, & reserve ratio, restrictions. So why bring back a constraint on reserves? Why limit reserves when banks are just facilitating the various transaction needs of their customers? The level of reserves has no effect on a bank’s lending. It's completely separate and different field of activity from reserve gathering and management.


Hans said...

Another master piece, Mr Rouge! I agree with your position, of which I could only understand in part...

I view the Central Bank as becoming more irrelevant as time passes along..

They have become part and parcel servants to the party in power and only serve to provide overnight liquidity..

They have run out of options and should go to church and pray for redemption...

They should begin to raise rate quarterly, to the tune of 25 bases points...

Why are banks not loaning?
There are 1.5 trillion dollars in excess reserves..My banker told me, they have the highest margins ever seen in the industry...He told me that the money loaned, is essentially free...Many small business are complaining that their banks are not making loans..

We have had three years of Fedzero and Bank Bernank has given his pledge of two more..

The Bank of America has become the Buffet's Bank of America..

Part of the aim of Fedzero, was to provide liquidity to the banks, which it managed..

I believe the financial industry is restructuring its balance sheet..Many loans have not been written off nor mark to market...

IMHO, the industry is hoarding money because their balance sheet is not whole...Their portfolios are riddle with questionable loans, which may default in the future...

Ponder this, how could Brazil have one of the best economies in the world with a Central Bank rate of 12%...

Rogue Economist said...

Thanks, Hans.

Although I'm not sure if the Fed should do anything anymore to move rates, even if to make it go up. Right now, I'm thinking just keep rates at zero, but neither should it pay interest on reserves. This way, banks don't make lending decisions based on fed rates, but on real market considerations.

Then banks should hold a large chunk of capital, and that should be the first to get a haircut when loans go sour. This is hardly a set position yet, I'm not sure if there's a downside to this approach. But Fed setting rates is too distortionary.

But what if fed just lends at zero to a bank that needs reserves for payment purposes. It would also lend at zero to a bank that wants to lend, but it will insist on a high capital equity ratio (higher than what it is now).

In any case, it will be the cost raising equity capital that will keep the bank from making loans that could be misallocated. The pain of losing their own equity should keep them from making sketchy loans, not zero fed rates. If any bank gets left with any excess reserves, they shouldn't get any wild ideas, and lend it to the first subprime who promises high yield.

I think Mosler is proposing something on this line, and I think it considers a lot of the unseen pitfalls and distortions that interest rate setting does to the financial market.

Hans said...

Mr Rogue, you are 100% correct on the payment of interest on reserves! I thought the QE's was designed to simulate lending, so what sense does it make to offer interest to bankers?

What about the 178 billion in loans that US banks have made to the Euro Zone, another reason for Fedzero and to keep liquidity in the banking sector?